Oil futures price convergence

Question

Looking at oil prices now:

• May: $20

• June: $26

• Spot: $20

According to the price convergence theory, the price of the May futures contract closely matches the spot price. This makes sense.

However, May futures are rolling over soon (Apr 21). Once rolled over, June futures become the main futures contract in variety of oil ETFs (USO, etc).

Assuming a scenario where the above prices remain constant until rollover date:

1. When this happens, does June futures start to decline to match closer with spot price?(June futures goes from 26 to 23, for example)

2. If this above happens, does this not create opportunity for arbitrage, where you can buy inverse ETFs to profit off of the convergence of June futures to spot oil?

Thanks!

Answer 1

There's not much opportunity to profit from an assumption. A reason is needed why oil will hold or decline during the next month. In fact the OPEC 9.7 million-barrel reduction in daily production begins on May 1 and oil prices might rise. Certainly if oil rises less than $6 a barrel then there would be a profit from holding a sell-position of a one-month oil futures contract.

But profiting from contango is a forward-sale and a hedge. The physical commodity is held while a futures contract is sold. But now, there is so much oversupply of oil that most oil storage is full.

Simply hold oil as a buy of the near-month futures contract and then sell a longer-term futures contract to get the contango ? That's considered a bull-spread that profits in a rising market. But with the contango currently so high then there might be other viewpoints. However, recently the near-month contract held while the longer-term months rose. The contango just widened on those who thought that they had advantageously locked it in.

Answer 2

We can expect spot to converge toward June futures rather than the other way around. Why? Futures are easily tradable and are arbitraged to fair value (eliminating excess profit opportunities). The current price of June futures reflects the expected value of those futures and of spot upon the June expiration. The current depressed spot price reflects the glut of oil and the high cost of storing excess oil. Arbitragers are betting that the glut recedes somewhat by June as production is reduced and existing oil is consumed, but that the cost of storing oil until then is $6 per barrel.